Brian Rountree

Cash Flow Introduction

Learning Objectives
• Cash flows
• Categorize cash flows into operating, investing, and financing activities
• Reconcile net income from the income statement to cash flows from operating
activities
• Learn how to use the cash flow statement to identify red flags related to
potential earnings management
Major Financial Statements

What is the financial How well did the

condition of the organization do
organization on a during a given
given day? period?

Balance Sheet Income Statement

Statement of Cash
Flows
Defining Cash Flow
• Cash flow is simply the change in cash.
• We can organize transactions to determine the change in cash due to:
• Operating activities
• Investing activities
• Financing activities

• By itself, the change in cash may not be that interesting, but properly
organized cash flow can tell us important things about a company.
Balance Sheet and Cash Flows
Assets = + Liabilities + Stockholders’ Equity
Cash + Noncash Assets = + Liabilities + Stockholders’ Equity
Cash = + Liabilities – Noncash Assets + Stockholders’ Equity
ΔCash = + ΔLiabilities – ΔNoncash Assets + ΔStockholders’ Equity

The three sections are generally categorized as follows:

Operating à + ΔCurrent Liab. – ΔCurrent Asset + Net Income

Investing à – ΔLong-term Asset
Financing à + ΔLong-term Liab. + Transactions
with owners

Net Income – ΔCurrent Assets + ΔCurrent Liabilities = CFO

Statement of Cash Flows
• Summarizes sources and uses of cash during a
given period

• Cash from operating activities (CFO)

• Generally, cash effects of transactions that affect income (involving changes in current assets
and current liabilities)
In: collections from customers; dividends received; interest received
Out: payments to suppliers, employees, etc.; tax payments; interest payments
Statement of Cash Flows
• Cash from investing activities (CFI)
• Generally, cash effects of transactions involving changes in long-term assets
In: sales of fixed assets, investment securities; collections of notes receivable
Out: purchases of fixed assets (capital expenditures), investments; lending money

• Cash from financing activities (CFF)

• Generally, cash effects of transactions involving changes in long-term liabilities and
stockholders’ equity
In: issuance of debt and equity securities
Out: share repurchases; debt repayments (principal only); dividend payments
Direct Method
• Lists each cash inflow and outflow
Operating Activities:
Collections from customers xxx
Payments to suppliers (xxx)
etc.
Investing Activities:
Capital expenditures (xxx)
Sale of equipment xxx
etc.
Financing Activities:
Issuance of common stock xxx
Repayment of debt (xxx)
etc.
Operating Cash Flow vs. Net Income
• Accounting accruals are the difference between revenues/expenses and operating cash
inflows/outflows
Net Income = Cash From Operations + Total Accruals
or
Net Income – Total Accruals = Cash From Operations
• Accruals include:
• Revenue/expense not recorded in same period as cash inflow/outflow
• Change in working capital accounts (current assets and current liabilities)
• Noncash items included in net income (e.g., depreciation expense)
• Thus, can indirectly derive cash from operations from net income
 Brian Rountree

Direct vs. Indirect Cash Flows

Learning Objectives
• Understanding the similarities and differences between a direct and
indirect statement of cash flows
• Only difference is how operating cash flows
are reported
• Investing and financing cash flows are always on
a direct basis
• Cash paid for property, plant and equipment ($10,000)
• Cash received from sale of stock $50,000
Direct Method
• Lists each cash inflow and outflow
Operating Activities:
Collections from customers xxx
Payments to suppliers (xxx)
etc.
Investing Activities:
Capital expenditures (xxx)
Sale of equipment xxx
etc.
Financing Activities:
Issuance of common stock xxx
Repayment of debt (xxx)
etc.
Operating Cash Flow vs. Net Income
• Accounting accruals are the difference between revenues/expenses and
operating cash inflows/outflows
Net Income = Cash From Operations + Total Accruals
or
Net Income – Total Accruals = Cash From Operations
• Accruals include:
• Revenue/expense not recorded in same period as cash inflow/outflow
• Change in working capital accounts (current assets and current liabilities)
• Noncash items included in net income (e.g., depreciation expense)
• Thus, can indirectly derive cash from operations from net income
Indirect Method
• Reporting of operating cash flows changes
Net Income xxx
+ Depreciation expense xxx
± Changes in working capital xxx
Cash Flows from Operations xxx

Investing and financing activities same as direct method

Investing Activities:
Capital expenditures (xxx)
Sale of equipment xxx
Financing Activities:
Issuance of common stock xxx
Repayment of debt (xxx)
Cash Flows
Balance Sheets
Assets Year 1 Year 2
Income Statement + Adjustments = Cash Flow
Cash $ - $ 66
AR $ - $ 135 Revenue $200
INV $ - $ 65
Prepaid Rent$ - $ 55
Prepaid Ins $ - $ 23
PPE $ - $ 98
Total $ - $ 442 COGS −$160
Liabilities
AP $ - $ 110
Notes Pay $ - $ 60
Rent −$5
Equity
RE $ - $ 32
Stock $ - $ 240
Insurance −$1
Total $ - $ 442
Depr. −$2
Income Statement Year 2
REV $ 200
COGS $ (160) NI $32
Rent $ (5)
Insurance $ (1)
Depr. $ (2)
NI $ 32
Cash Flows
Balance Sheets
Assets Year 1 Year 2
Income Statement + Adjustments = Cash Flow
Cash $ - $ 66 Cash
AR $ - $ 135 Revenue $200 ∆ AR −$135 = Received $65
INV $ - $ 65
Prepaid Rent$ - $ 55
Prepaid Ins $ - $ 23
PPE $ - $ 98
Total $ - $ 442 COGS −$160
Liabilities
AP $ - $ 110
Notes Pay $ - $ 60
Rent −$5
Equity
RE $ - $ 32
Stock $ - $ 240 Insurance −$1
Total $ - $ 442

Income Statement Year 2

Depr. −$2
REV $ 200
COGS $ (160) NI $32
Rent $ (5)
Insurance $ (1)
Depr. $ (2)
NI $ 32
Cash Flows
Balance Sheets
Assets Year 1 Year 2
Income Statement + Adjustments = Cash Flow
Cash $ - $ 66 Cash
AR $ - $ 135 Revenue $200 ∆ AR −$135 = Received $65
INV $ - $ 65
Prepaid Rent$ - $ 55
Prepaid Ins $ - $ 23 ∆ INV −$65
PPE $ - $ 98 Cash
Total $ - $ 442 COGS −$160 = Paid for −$115
Inventory
Liabilities ∆ AP +$110
AP $ - $ 110
Notes Pay $ - $ 60
Rent −$5
Equity
RE $ - $ 32
Stock $ - $ 240 Insurance −$1
Total $ - $ 442

Income Statement Year 2

Depr. −$2
REV $ 200
COGS $ (160) NI $32
Rent $ (5)
Insurance $ (1)
Depr. $ (2)
NI $ 32
Cash Flows
Balance Sheets
Assets Year 1 Year 2
Income Statement + Adjustments = Cash Flow
Cash $ - $ 66 Cash
AR $ - $ 135 Revenue $200 ∆ AR −$135 = Received $65
INV $ - $ 65
Prepaid Rent$ - $ 55
Prepaid Ins $ - $ 23 ∆ INV −$65
PPE $ - $ 98 Cash
Total $ - $ 442 COGS −$160 = Paid for −$115
Inventory
Liabilities ∆ AP +$110
AP $ - $ 110
Notes Pay $ - $ 60
= Cash
Equity
Rent −$5 ∆ PreP −$55
Paid
−$60
RE $ - $ 32
Stock $ - $ 240 Insurance −$1
Total $ - $ 442

Income Statement Year 2 Depr. −$2

REV $ 200
COGS $ (160)
Rent $ (5) NI $32
Insurance $ (1)
Depr. $ (2)
NI $ 32
Cash Flows
Balance Sheets
Assets Year 1 Year 2
Income Statement + Adjustments = Cash Flow
Cash $ - $ 66 Cash
AR $ - $ 135 Revenue $200 ∆ AR −$135 = Received $65
INV $ - $ 65
Prepaid Rent$ - $ 55
Prepaid Ins $ - $ 23 ∆ INV −$65
PPE $ - $ 98 Cash
Total $ - $ 442 COGS −$160 = Paid for −$115
Inventory
Liabilities ∆ AP +$110
AP $ - $ 110
Notes Pay $ - $ 60
= Cash
Equity
Rent −$5 ∆ PreP −$55
Paid
−$60
RE $ - $ 32
Stock $ - $ 240 Cash
Total
Insurance −$1 ∆ PreP −$23 =
Paid
−$24
$ - $ 442

Income Statement Year 2 Depr. −$2

REV $ 200
COGS $ (160)
Rent $ (5) NI $32
Insurance $ (1)
Depr. $ (2)
NI $ 32
Cash Flows
Balance Sheets
Assets Year 1 Year 2
Income Statement + Adjustments = Cash Flow
Cash $ - $ 66 Cash
AR $ - $ 135 Revenue $200 ∆ AR −$135 = Received $65
INV $ - $ 65
Prepaid Rent$ - $ 55
Prepaid Ins $ - $ 23 ∆ INV −$65
PPE $ - $ 98 Cash
Total $ - $ 442 COGS −$160 = Paid for −$115
Inventory
Liabilities ∆ AP +$110
AP $ - $ 110
Notes Pay $ - $ 60
= Cash
Equity
Rent −$5 ∆ PreP −$55
Paid
−$60
RE $ - $ 32
Stock $ - $ 240 Cash
Total
Insurance −$1 ∆ PreP −$23 =
Paid
−$24
$ - $ 442

Non-
Income Statement Year 2 Depr. −$2 cash +$2 = $0
REV $ 200
COGS $ (160)
Rent $ (5) NI $32
Insurance $ (1)
Depr. $ (2)
NI $ 32
Cash Flows
Direct Method
Balance Sheets
Assets Year 1 Year 2
Income Statement + Adjustments = Cash Flow
Cash $ - $ 66 Cash
AR $ - $ 135 Revenue $200 ∆ AR −$135 = Received $65
INV $ - $ 65
Prepaid Rent$ - $ 55
Prepaid Ins $ - $ 23 ∆ INV −$65
PPE $ - $ 98 Cash
Total $ - $ 442 COGS −$160 = Paid for −$115
Inventory
Liabilities ∆ AP +$110
AP $ - $ 110
Notes Pay $ - $ 60
= Cash
Equity
Rent −$5 ∆ PreP −$55
Paid
−$60
RE $ - $ 32
Stock $ - $ 240 Cash
Total
Insurance −$1 ∆ PreP −$23 =
Paid
−$24
$ - $ 442

Non-
Income Statement Year 2 Depr. −$2 cash +$2 = $0
REV $ 200
COGS $ (160)
Rent $ (5) NI $32 CFO −$134
Insurance $ (1)
Depr. $ (2)
NI $ 32
Cash Flows
Indirect Method
Balance Sheets
Assets Year 1 Year 2
Income Statement + Adjustments = Cash Flow
Cash $ - $ 66 Cash
AR $ - $ 135 Revenue $200 ∆ AR −$135 = Received $65
INV $ - $ 65
Prepaid Rent$ - $ 55
Prepaid Ins $ - $ 23 ∆ INV −$65
PPE $ - $ 98 Cash
Total $ - $ 442 COGS −$160 = Paid for −$115
Inventory
Liabilities ∆ AP +$110
AP $ - $ 110
Notes Pay $ - $ 60
= Cash
Equity
Rent −$5 ∆ PreP −$55
Paid
−$60
RE $ - $ 32
Stock $ - $ 240 Cash
Total
Insurance −$1 ∆ PreP −$23 =
Paid
−$24
$ - $ 442

Non-
Income Statement Year 2 Depr. −$2 cash +$2 = $0
REV $ 200
COGS $ (160)
Rent $ (5) NI $32 CFO −$134
Insurance $ (1)
Depr. $ (2)
NI $ 32
 Brian Rountree

Cash Flows From Operations

• Purchases and sales of PP&E are cash outflows and
inflows, respectively.
• Always included in the cash flows from investing
activities of the cash flow statement.
• Thus, depreciation must be added back in the operating
section in order to eliminate the effect on net income to
arrive at cash flows from operations.
• Loss on disposal in CFO of $14 is shown as an add back
to net income (likely included in “other income” on
income statement).
• However, all cash flows show up in investing section,
thus when reconciling from NI to CFO, must eliminate
gains/losses.
• Losses (gains) eliminated by adding back (subtracting) amount
since was subtracted (added) to arrive at NI
 Brian Rountree

Vera Bradley CFO, Part 2

Inventories
• Did inventories increase or decrease at Vera Bradley for the year
ended January 28, 2017?
• You should be able to tell directly from the change reported in the operating
section of the statement of cash flows.
• Inventories went down $11,307 ($102,283 – $113,590).
• Recall decreases in current assets are cash inflows,
whereas increases in current assets are cash outflows.
 Brian Rountree

Cash Flows From Investing and Financing

• Ultimately, the cash flow statement explains how the
balance sheet’s beginning cash balance changed to
arrive at the ending cash balance as seen above.
 Brian Rountree

Non-Articulating Items
Issues With the Statement of Cash Flows
• We have assumed that all changes in working capital accounts are due to operating
activities.
• Changes on Balance Sheet reconcile exactly with changes on Statement of Cash Flows
• In practice, working capital accounts may change due to nonoperating activities,
including:
• Mergers and acquisitions
• Divestitures
• Foreign currency translation adjustments
• Reclassifications
• Accounting changes
• Roughly 75% of all companies are affected by nonarticulating items
• Thus, changes on the balance sheet with changes on the statement of cash flows usually
cannot be reconciled.
 2017 2016 Change
Receivables, net 5,835 5,624 211
Inventories 43,046 44,469 (1,423)
Walmart’s Cash Flows
Changes in certain assets and liabilities, net of effects of acquisitions:
Receivables, net (402)
Inventories 1,021

2017 2016 Change

Changes calculated from the Balance Sheet:
Receivables, net 5,835 5,624 211
Inventories 43,046 44,469 (1,423)

?
Walmart’s Cash Flows (cont.)
• Why do the changes per Walmart’s cash flow statement not agree with changes
per the balance sheet?
• Likely because of M&A activity
• Walmart purchased Jet.com in September of 2016
Purchased corporations’ assets and liabilities do not show up in the previous year, yet they do in the
current year. The changes calculated from these balances do not properly account for the combined
entities’ cash flows.
Non-Articulating Items
• Why do activities like mergers and acquisitions and divestitures
(selling off subsidiaries) lead to disagreement between balance sheet
changes and cash flow statement changes (i.e., non-articulating
items)?
Hypothetical Acquisition
• Assume Rountree Candies purchases Koka Cola in this fiscal year.
• Below are the separate amounts of inventories for the two organizations for the
last two fiscal years.

Year t Year t-1 Change

Rountree Candies 1,200 1,400 (200)
Koka Cola 450 575 (125)
Hypothetical Acquisition
• The combined entities’ balance sheets will be as follows:

Year t Year t-1 Change

Rountree Candies 1,200 1,400 (200)
Koka Cola 450 575 (125)
Combined 1,650 1,400 250

• Rountree Candies does not own Koka Cola in year t-1.

• Since balance sheets are snapshots at a given point in time, only report $1,400
for inventories in t-1, but then in year t Rountree owns Koka Cola, thus includes
combined inventories.
• Balance sheet change no longer properly reflects cash flow implications of
changes in inventory, which should be a decrease of $325, instead of an increase
per the balance sheet of $250.
Issues With the Statement of Cash Flows
• In practice, working capital accounts may change due to non-operating
activities.
• Mergers and acquisitions
• Divestitures
• Foreign currency translation adjustments
• Reclassifications
• Accounting changes
• Roughly 75% of all companies are affected by non-articulating items
• Thus, changes on the balance sheet with changes on the statement of
cash flows usually cannot be reconciled.